If you want to change the face of your bank, one of the fastest ways to do it is by changing the compensation structure. Incentive plans for lending staff can influence a bank’s financial performance – both positively and negatively. Well-designed incentive plans can create tremendous shareholder value by generating improved credit quality, higher cross-sell opportunities and cheaper deposits. However, incentive plans that are not results-oriented and do not align the bank’s objectives with lender compensation result in lower ROA, higher credit losses and poor balance sheet management.
Best practice in incentive plans is to align the bank’s credit goals with lenders’ compensation. That means that lending results should be measured on a risk-adjusted basis. Too often banks only measure and compensate lending staff on net interest margin, or revenue or volume. The result is that lenders will naturally (and often not consciously) maximize net interest margin, revenue or volume but to the detriment of credit quality.
Some managers will point out that it is a loan committee’s job and not the lender’s to assess and adjudicate on credit quality. However, this is not how credit departments and loan committees function. In reality, a bank’s board will set a somewhat ambiguous risk tolerance for loans. Management will then set some loan volume targets. The loan committee will assess credit risk partly in absolute terms but also in relative terms based on all loans reviewed. That means that a typical loan committee will approve a percentage of the best deals that they will see in a year. If the credit officer only sees C, D and E credits, that officer will favor the C credits. However, if an officer sees A, B and C credits, they may approve more credits in total, but they will most certainly also approve the vast majority of the A and B credits presented.
The argument that loan committee or the credit department will save the bank’s capital by declining riskier deals is flawed. The loan risk spectrum is not “loans that we will do” and “loans that we will not do.” The credit spectrum is very broad. By incenting your lenders on non-credit measures like NIM or volume, banks are positioning their credit departments to accept more bad loans.
The correct incentive plan will pay lenders to submit and book loans ranked on a risk-adjusted basis.
Lenders should also be incented for bringing in relationships and not just loans. The loan is a platform that brings the customer to the bank. The well-run bank then works to convert that platform to various profitable products such as deposits, transaction business and other profitable credits. Incentive plans should measure the entire scope of the bank’s relationship with the customer – that measure should include the entire relationship ROA. Lenders that can garner more of the customer’s share of wallet are more valuable to the bank then lenders that only generate loans.
Minimum Credit Spread
Banks that require lenders to achieve a minimum margin over cost of funding are doing their shareholders a disservice. We find that two things happen when lenders are told to achieve minimum spread: 1) There becomes a race to the bottom and every deal is the best credit the lender has seen and loans are often priced near the minimum spread; and 2) The larger credits, better credit quality loans and relationship credits become priced out of the bank’s target spread. The end result is that good credits are over-priced and bad credits are underpriced resulting is suboptimal ROA for the bank. This is the major problem of basing incentives on target credit spreads.
Stability of Relationship
Most lender incentive plans do a poor job of measuring lifetime value of the customer. The key to profitability in relationship banking is to keep the customer for as long as possible with minimum overhead for the bank. So banks should naturally be targeting long-term and low maintenance accounts that will buy additional products. Unfortunately, lenders may have a different motivation. Some lenders may be drawn to short-term business that comes with upfront fees because a lender may be compensated on the fees they generate. Other lenders will be interested in short-term business because they can rebook the business every year to meet their volume targets. Still other lenders are keen on booking short-term business because they can take the account with them if they ever change employers.
Banks must be able to measure lifetime value of a relationship and incent lenders that can maximize long-term and stable revenue for the bank.
Banks must set incentive plans for lenders based on multiple measures. Those measures must take into account the risk-adjusted return on assets of a loan based on credit quality, lifetime value of the relationship, size of the credit, and total cross-sell revenue. Incentive plans that simply target minimum loan volume and some minimum interest spread tend to be counterproductive to the bank’s goal of maximizing long-term ROA and shareholder value.
Submitted by Chris Nichols on January 21, 2016